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The stocks powering the best performing UK equity income fund of 2016 so far

10 April 2016

Evenlode Income has followed three years of outperformance with a sector topping run in the first quarter of 2016.

By Daniel Lanyon,

Senior Reporter, FE Trustnet

Good income opportunities persist in areas of the market such as media and consumer staples despite a host of concerns for equities, according to Hugh Yarrow (pictured), manager of the Evenlode Income fund.

Yarrow, whose fund is the fifth best performer in the 67-strong IA UK Equity Income sector since it launched back in October 2009 and is also first in the sector in 2016 so far, sees plenty to be concerned about but thinks four distinct areas of the market are offering “sustainable” income opportunities.

Performance of fund, sector and index since launch

  

Source: FE Analytics

“A number of macro clouds continue to loom large on the horizon. China’s economic slowdown, the risk of Brexit, a hugely volatile oil price and negative interest rates are just some of challenges the world economy faces,” he said.

“The extent to which companies are coping with global economic headwinds might charitably be described as mixed.  However, we have been very reassured by the resilient performance and dividend growth produced by a number of stocks within a diverse group of UK equity sectors.” 

In this article, we take a look at the four sectors making Yarrow most bullish for the prospect of dividends.

 

Software

 

Software firms make up the Evenlode Income fund’s second biggest sector exposure at 14 per cent, with Yarrow initiating new holdings in recent months in Fidessa, which specialises in financial services software, and Aveva, which operates in the industrial space.

“As with consumer branded goods, customer loyalty makes for attractive economics and high recurring revenues. Even for Aveva, whose software is used by engineers to design and maintain facilities such as oil refineries and power plants, the mission-critical nature of its products continues to provide pricing protection and good contract renewals,” Yarrow said.


“As management put it to us recently, the software component as a proportion of total project costs is tiny and you just can’t spec it out. These companies are also enjoying a good tailwind of structural growth as companies increasingly utilise software to drive up productivity.”

Both Fidessa and Aveva are ahead of the FTSE All Share over one year but – particularly in the case of Aveva – have come under significant pressure at various moments. Aveva took a huge hit in December when its proposed £1.3bn deal with Schneider Electric stalled.

Performance of stocks and index over 1yr

Source: FE Analytics

 

Media

Over the past three years, media has been a strongly performing part of the UK equity market with a gain nearly four times that of the FTSE All Share.

Performance of indices over 3yrs

 

Source: FE Analytics

Yarrow thinks smaller cap media names are offering good value, with his exposure predominately taken through business-to-business information companies Informa, DMGT, Relx and Euromoney,  where there is a high level of digital content.

“Like our software names, they enjoy low capital intensity and repeat-purchase cash flows. They also have plenty of growth potential as customers look to utilise information and data analytics to improve their own products and increase efficiency.”

“Relx’s relentless mantra on organic development is impressive. We think the real value is taking platforms and content and developing them into increasingly more sophisticated analytics and decision-making tools. This creates more value for clients, and has a far higher return on capital in the longer term.”


“We have also been encouraged by Informa’s progress over the last year, as the company’s investment programme begins to gain traction. As its CEO Stephen Carter says of this super-specialist business – it has become the ‘God of Small Things’.”

 

Healthcare

Yarrow cut back the fund’s healthcare exposure in the first few months of the year to 12 per cent as due to a belief that opportunities for better returns exist elsewhere.

Healthcare has been one of the best places to invest over recent years but has been broadly selling off over anticipation that a win for Hilary Clinton in the 2016 US presidential election will be negative for the sector if she implements a pledge to impair drug price inflation.

Despite this, Yarrow says he continues to like the healthcare industry’s high barriers to entry, economic insensitivity and the potential for growth thanks to innovation and demographics.

“We also like the sector’s asset-light nature (these are companies for which intangible assets such as research expertise are key). In terms of recent results, Johnson and Johnson clearly demonstrated these qualities, generating strong free cash flow and a dividend increase of 7 per cent.”

 

Consumer branded goods

 

Last up is a firm favourite of Yarrow, who has been overweight firms such as Unilever, P&G and Diageo for several years.

It still makes up 30 per cent of the fund. The emerging market slowdown was the big theme for these companies again in 2015, just as it was in 2014,” he said.

“Tough operating conditions are the new normal and businesses have made adjustments and management teams are not planning for an improvement any time soon. However, those companies with a focus on repeat-purchase products have kept cash flow coming.”

“As dividend growth investors, we have a structural bias towards these business models. The dividend performance of companies like Unilever and Diageo is a reminder of why: both stocks have posted an 8 per cent annual growth figure over the last five years.”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.